'Snowballs get bigger as they run downhill.'

What with the EU summit of 26 October, the announcement and then the abandonment of the Greek referendum, and last Friday’s G20 summit, the last two weeks have certainly been turbulent for the eurozone. At the end of the fortnight, it's increasingly evident that the authorities are unable to find a solution to the crisis.

The 26 October summit, frequently referred to as the 'last chance' (and the 14th in 21 months), resulted in 3 decisions:

- ‘optimisation’ of the European Financial Stability Facility (EFSF) through leverage;

- a voluntary 50% ‘haircut’ on Greek debt;

- a bank recapitalisation of 106 billion euros between now and the end of June 2012 to arrive at a capital ratio of 9% for the banks.

These decisions triggered a mighty rebound on the stock markets on 27 October. But the response of the bond markets was distinctly more lucid: after briefly easing, the 10-year Italian bond yield rapidly started to climb again and has since definitively passed the 6% mark. The spread between French and German bonds has continued to widen and now stands at a 20-year record.

10- year interest rate spread between France and Germany

A plan without details

The bond markets soon saw that what was sold as a plan for a solution in fact boiled down to a few grand declarations followed by a stark lack of detail. A number of questions surround each of the three decisions taken:

1. the voluntary haircut on Greek debt:

- which creditors will have to accept the 50% write-off? Greek debt currently amounts to around EUR 350 billion. 150 billion are held by the ‘Troika’ (the European Central Bank, the International Monetary Fund and the European Commission) and won’t be affected by the discount. Thus the European Commission no longer represents 50%, only 30%. Of the remaining 200 billion, around 85 billion are held by banks and Greek pension funds and it is highly likely that the latter will do their utmost to avoid the write-off. If so, the actual discount would be 16%;

- the nuts and bolts of the write-off that the banks are required to ‘voluntarily’ support have yet to be negotiated. And there is no certainty that all the banks concerned will actually participate in the plan;

- what’s to stop other countries demanding a trim of their debt too?

Finally, the decision to make this discount a ‘voluntary’ event to avoid it being a ‘credit event’, which would trigger the payment of CDS (Credit Default Swaps), is likely to prove counterproductive. Why would an investor go on buying default insurance if it is obvious that it has no sound legal basis? And if the insurance isn’t valid, why buy the debt of peripheral countries?

2. recapitalisation of the banks:

- why does the European Bank Authority set the capital requirements at only 106.4 billion (we must at least applaud them for the detailed figure) whereas the International Monetary Fund’s estimate is double that amount?

- on what assumptions has the EBA based this figure? And what about a potential partial default on the debt of other countries in the eurozone?

- what if the banks decided to increase their equity ratio by decreasing their assets rather than by recapitalising (selling government bonds for example)?

- what will be the impact on the banks’ willingness to lend (and therefore on economic growth... and therefore on the quality of private and public debt... and therefore on the banks’ equity... etc. etc.)?

- what benefit would there be to private investors in recapitalising banks which have been more or less prohibited from paying dividends? If there is a lack of interest from private investors, the necessary capital will have to come from governments, generating a new round of public debt increases with consequences on their rating and their capacity to service their debt.

It is important to note that a credible recapitalisation of the banks is an indispensible condition for a return to confidence in them. And a return to confidence is all the more necessary given that the European banks will have to refinance some 600 billion euros of debt maturing in the next 12 months.

3. optimisation of the EFSF resources:

- first, it is ironic to note that the solution to a crisis provoked among other things by excess leverage is supposed to come from introducing significant leverage into the EFSF. A problem caused by too much debt won’t be resolved by adding even more debt;

- one of the possibilities envisaged seems to be for the EFSF to guarantee the first 20% of the loss in the event of payment default by a member of the eurozone, with this guarantee only being valid for newly issued debt. In practice, it’s not very clear how this is supposed to operate. In the first place, it is odd to offer this type of guarantee to an investor for government bonds issued by developed countries, given that this kind of debt is supposed to be of the ‘highest quality’ and therefore risk-free. In explicitly recognising that this is no longer the case, the European authorities are turning bonds into risk assets, thereby increasing the cost of financing of the countries concerned on a long-term basis. Increasing the EFSF’s resources through leverage won’t reduce the risk of default; it will just cause a change at the level of the losers – private lenders or tax payers. Secondly, history shows that when a country defaults, the loss incurred by its creditors is rarely limited to 20%. And thirdly, if the guarantee only covers newly issued bonds, this solution will create a two-tier market with new bonds and old bonds at separate levels;

- the idea of linking the EFSF to a special fund in which private investors and non-member countries of the eurozone could participate is also peculiar. Why would these lenders want to put money into such a fund if (for example) Germany is not prepared to contribute more money to the EFSF? Not to mention the fact that the idea of asking for help for the eurozone from countries like China and India, which despite the size of their currency reserves are still relatively poor, is frankly embarrassing.

- Ultimately, the EFSF represents an empty box filled with promises of a money given by countries that may well have to borrow that same money. Regarding the potential size of this empty container, the Financial Times summarised the situation very neatly in its edition on 28 October, noting that the fund’s size is ‘an estimate based on the still-untested ability to multiply a still-unknown asset base by four to five times’.

A crisis of confidence

Having started off by indicating that the idea of a partial default of Greece was absurd, then that Greece’s problems were not going to knock-on to other eurozone countries, then that the European banks were adequately capitalised, the European authorities finally proposed a plan which does nothing to reinforce investor confidence in the debt of peripheral countries or in European banks. Two crucial objectives have not been reached. Contagion to other countries in the periphery, and even from South to North, has not been stopped and confidence in the banks has not been restored. As for Greece, the plan will condemn it to years of austerity and high unemployment with the sole promise of eventually reducing its public debt to 120% of its GDP, which is double the 60% figure used for Maastricht.

A fiscal union?

It is obviously easy to criticise. But the fact is that the eurozone problems are so numerous and complex (high public debt, interdependence between state and banks, under-capitalisation of the banks, lack of competitiveness in the South, etc.) that it’s hard to find a solution. These problems are mainly due to the fact that, economically, monetary union between countries as different as Germany and Greece never made any sense and that the type of economic environment that enabled this union to function for a few years in spite of everything, is no longer there and isn’t about to return anytime soon. The absence of fiscal union has done nothing to improve the situation. Such a fiscal union does not seem to be about to happen. On the one hand, the public finances in Germany are not particularly brilliant, especially when future expenditure based on an ageing population is taken into account. On the other hand, the euro is almost a relic of the cold war. Today, the economic and geopolitical links between the eurozone countries are weakening. There was greater integration between the eurozone countries in the three decades before the advent of the single currency. It is hard to imagine Germany sharing its sovereignty on taxation (which fiscal union would require) with countries whose interests are not necessarily the same. And even if it did, the conditions that it would impose in return would be likely to make these countries run away.

Germany's dominant position

If, for now, Germany seems to be prepared to work for the survival of the eurozone in its current form, it’s because the weakness of other countries allows it to impose its views. Greater participation by banks in Greece’s default, the refusal to transform the EFSF into a bank, increased budgetary surveillance of countries in difficulty and the refusal to accept a more significant role for the European Central Bank in financing governments are all points on which Germany’s wishes have prevailed over other countries, especially France. It should also be noted that since the beginning of 2010, the German 10-year bond yield has declined from 3.4% to 1.8%. The crisis has therefore enabled Germany (and Northern Europe in general) to significantly reduce its cost of financing while this cost has soared in Southern Europe. This will only exacerbate the competitive differential between North and South.

Numerous observers have criticised Germany’s position on a greater role for the ECB in financing the periphery countries. It is true that in enabling the central bank to print money to lend to the periphery countries or to the EFSF, it would be possible to temporarily resolve the current crisis and delay its endgame. Countries in difficulty would then hardly have good reason to sort out their public finances though. History also shows that the easy solution of printing money has very undesirable consequences in the medium and longer term with inefficient capital allocation and rampant inflation. The fact that Germany is opposed to such a solution should therefore be applauded. But in a context where the rules of the free market economy are being increasingly suspended by the authorities, there is no certainty that the German government won't give way in its turn. (It is also ironic that some people consider that the market economy is responsible for the current crisis when, in fact, it is the failure to abide by the rules of such an economy that is the cause: artificially low interest rates for several years, protection of the banks against the consequences of their actions, capital directed to activities that do not create real added value, refusal to allow the disappearance of non-profitable companies, monetary union defying economic laws etc.).

Although the German position therefore seems to reinforce Article 123 of the Treaty of Lisbon, barring the European Central Bank from buying up the debt of Member States, it also substantially reduces the possibility of the eurozone’s survival in its current form. The solution recommended by Germany of budgetary discipline and general austerity will not be able to function either. It would plunge the peripheral countries into a vicious circle, with dangerous social and political consequences.

In my article on 6 July, I wrote that the eurozone crisis also poses the question of Europe’s governance. Until now, the creed of the European authorities had been to say that, whatever the cost, the single currency must be defended in its current form. This position seems to have moved on during the past week with the announcements by Angela Merkel and Nicolas Sarkozy that Greece was free to leave the euro. In this respect, the idea of a referendum mooted by the Greek Prime Minister was far from absurd. Asking the Greek people if they would prefer to submit to years of austerity or suffer the consequences of leaving the euro should form part of the democratic process after all. However, since decisions concerning the European process have only rarely been taken democratically, the general uproar that greeted the announcement of the referendum was hardly surprising.

A lack of growth

To sum up, Europe has numerous problems, starting with the debt overhang. To reduce excessive debt (in relation to GDP), the most agreeable solution is economic growth. However, this solution does not look realistic at the present time, given that the money spent in recent years wasn’t spent to increase the medium and long-term growth potential of the eurozone. On the contrary, the lack of growth (reinforced by budgetary austerity) risks further aggravating the problem. Three possibilities remain:

- transfer the debt from highly indebted countries to less indebted countries through some kind of fiscal union;

- inflation to reduce the real cost of the debt;

- write down the debt.

Because of its history, Germany has a very strong anti-inflationary bias, unlike the Southern countries. Since it is in a position of strength to impose its view of things, the first two solutions are therefore off the table. Regarding the third solution, the German position is that a default on government debt should first impact private creditors, then the countries affected, and only then the eurozone as a whole. For a country to obtain partial default on its debt, it will have to submit to control by its European partners or the International Monetary Fund, with these somehow taking over the day-to-day management of the country. This is likely to enrage the population of the country in question which would take a very grim view of being supervised. But on the other hand, not imposing strict controls would mean rewarding the country for its poor management and would not encourage it to engage in structural reform. It’s a vicious circle.

Seeking people to blame for the current situation is a pointless exercise! Germany may reproach the Southern countries for their lack of discipline, while in their turn they will retort that it’s this very lack of discipline that is at the origin of the German surpluses by creating demand for German products. Rather than wanting to obtain even more powers to try and settle the crisis and thus strengthen anti-European sentiment among their people, the European leaders need to recognise their responsibility in the current problems and reflect on how to reduce monetary union to something that is viable for the long term. This will mean recognising that in its current form it isn’t!